Growth in Spain again exceeded expectations this year, and bank deleveraging appears to have reached an end. Addressing non-performing loans was a precondition for recovery, and it required comprehensive financial sector reform.

Recent figures for bank lending in Spain suggest that more than seven years of deleveraging from domestic lending to households and enterprises are about to come to an end (see chart). Volumes of new lending to households and SMEs have registered growth since early 2014. This represents an important turnaround for a banking sector that threatened sovereign market access only four years ago.

The health of the sector has improved considerably since then. The NPL ratio has now fallen to 9.4 per cent of total loans, as the concentration in real estate assets was much reduced. In 2015 alone this represented a fall by over one fifth in the stock of distressed assets.

Following the sharp provisions in 2012 the sector has been modestly profitable, currently with a 6.8 per cent return on equity (RoE) according to data from the European Banking Authority. This made it possible to rebuild capital ratios. Moreover, despite years of deleveraging at home, key banks continued to expand a profitable foreign business – in Europe and, until recently, in Latin America.

In the third year of recovery from the crisis, growth continues to outpace expectations (as in the Commission’s just released November forecasts). The further expansion in firms’ capital expenditures now appears to be feeding through into stronger demand for bank credit.

Lending rates for both large enterprises and SMEs have effectively converged to those charged in core euro-area countries, such as Germany. This is a striking contrast with the situation in early 2013, when credit to enterprises was falling at an annual rate of almost 8 per cent, and the premium over lending rates in Germany was in excess of two percentage points.

The €100 billion financial sector programme for the euro area of 2012-14 was only partially utilised, but appears to have been successful in rebuilding confidence.

In the run-up to the crisis the supervisor did not rein in the housing bubble. A culture of forbearance took hold in the cajas sector (see this account of the failures). Innovative regulation, such as the system of dynamic provisioning, proved inadequate in the face of the ultimate capital shortfall. Today, confidence in capital coverage and the valuation of banks’ assets appears to have been rebuilt, not just according to the Commission’s own evaluation earlier this year.

Addressing the NPL overhang was clearly essential for the recovery of the Spanish banking sector.

A first precondition for NPL reduction was the comprehensive bottom-up stress test of 2012, which provided relative certainty for asset valuations. Spain’s bad bank, Sareb, was established later that year. The transfer of distressed real estate assets totalling EUR 106 billion was compulsory for those banks receiving public capital injections. This isolated the financial stability risk posed by the uncertain value of real estate portfolios.

As a central asset management institution tasked with restructuring real estate assets, and acting as a central counterpart for investors, Sareb was a key catalyst in building the market for distressed assets. But it took several years before a liquid market in such assets emerged. Today, Spain has the third most active market for loan portfolio sales in Europe, according data from advisory firm KPMG.

It is clear that tackling NPLs was central to the recovery of the sector. A high volume of NPLs undermines bank performance for various reasons: the reduction in interest income; mounting impairment costs; costs of capital on assets that attract higher capital charges; and higher funding costs as investors expect diminished earnings streams. There are less direct but equally tangible effects as management is increasingly distracted by servicing a stock of distressed assets rather than generating new lending business.

The strong relationship at bank level is borne out in a correlation of aggregate NPL ratios and growth figures (see for instance this IMF study). Adverse growth effects are more severe where the industrial structure is dominated by SMEs which depend more on external bank credit, as was the case in Spain.

Non-performing loans in Spain were concentrated in the real estate sector, and hence benefited from Sareb’s relatively successful and focused business model. Once NPLs were cleared off the banks’ books, the recapitalisation and consolidation in the sector supported renewed loan growth and value recovery.

NPL resolution in Spain remains far from complete, and the stocks of repossessed houses on the banks’ balance sheets, and of refinanced loans that are classified as performing are still high. Still, the relative success in resolving Spain’s NPL problem offers some lessons for other euro-area countries still labouring under an overhang of bad loans.

NPL reduction succeeded only in the context of a comprehensive financial sector restructuring and recapitalisation. GDP growth resumed in 2014 and contributed to a recovery in real estate values and investor interest. Bank recovery was backed up with a number of reforms in the restructuring framework, for instance the changes in the restructuring regime which offered a ‘fresh start’ for enterprises and households. In its assessment in September the ECB found fewer concerns in Spain than in the average of the eight euro area countries it examined.

Needless to say, NPL reduction is no silver bullet, and the Spanish banking sector still suffers from the low interest rate environment just as most other euro-area banking markets do. Intense competition has pushed down interest margins, and appears to have led to an easing of lending standards that now attracts the attention of the supervisor and rating agencies. But it can still be argued that NPL reduction was a vital component of Spain’s post-crisis financial and wider economic recovery.

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